Speaking Volumes

A central feature of global stock markets this year has been the shriveling of trading volumes. Truth to be told, the problem didn’t begin this year but rather has been developing for several years, since the crash of 2008/09 and during the period of the subsequent recovery in markets. But there is no doubt that 2012 has seen the problem worsen considerably.

Because it is a global problem, it can only be spoken of in general terms. This perforce ignores the fact that there are differences between regions and certainly between countries, so that – again as a generalization – volume has shrunk much more in developed markets than in developing markets. Asia-Pacific, as a region, has been better off than North America and certainly than Europe. But the fact that there is an overall shrinking trend at work demands an explanation, and that’s where things begin to get difficult. First of all, no-one knows for sure what the explanation/s is or are, if there are several, let alone how much weight to accord each one. Secondly, some of the proposed explanations are highly embarrassing.

The best example of this is the US, traditionally viewed as the home of the largest and most liquid stock market. At least the latter part of that statement is now open to debate, and maybe inaccurate or just plain wrong. Is the US market liquid? In a technical sense, yes it is. But it is also now a well-known fact that a great deal of this liquidity, perhaps even most of it, is generated by a very small group of financial institutions who indulge in very intensive trading via extremely sophisticated computerized systems. This set-up goes under the label “HFT”, meaning high frequency trading, in which vast numbers of orders are generated at incredible speed on an ongoing basis. Without HFT, the overall volume would obviously be much less, but that also reflects the fact that over the last few years the general public – the legendary retail investor who used to be the mainstay of the US market – has largely withdrawn from the equity market. That is apparent in the prolonged trend of net redemptions from equity-oriented mutual funds, which were the traditional vehicle through which most retail investors participated in the market.

There is a widespread suspicion, backed by considerable anecdotal evidence although not formally ‘proven’, that the withdrawal of private investors has been caused by and is a reaction to the growing dominance of the HFT players. In simple terms, households have internalized the fact that the market is now entirely inhospitable to them and their role is merely to be the cannon fodder from which the large institutions generate both commissions and trading profits. Having tumbled this game, the public is exiting the market, causing volumes to shrink, ‘flash crashes’ caused by ‘berserk algos’ (meaning malfunctioning computerized trading programs) to proliferate and resulting in some institutions seeing their income and profits from these sources shrink. In a growing number of cases, their response has been to actually close trading desks and fire traders.

Nevertheless, many firms still make big bucks from HFT, and that explains the fiercely negative response to proposals announced this week by Germany to partially restrain some of the more egregious aspects of HFT. The Wall Street Journal reported that one of the proposals would be “a requirement for orders to rest on the exchange order book for a minimum of half a second before they can be canceled or modified, and penalties for high cancellation rates” which, the paper noted was “an eternity for firms accustomed to trading in millionths of a second”. That gives some idea of the gulf between the environment in which ordinary people submit orders and conduct their trading – even if they do it online, as most do nowadays — and the rarified atmosphere of HFT, in which being physically close to the exchange and its computers confers an advantage, because of the nanoseconds gained by having the electronic signals travel very short distances.

The Germans are at least prepared to contemplate what the Americans will not, namely clipping the wings of the big players and thereby making the playing field slightly more even again. The struggle between the ‘fat cats’ and the retail investors, in the US and Europe, will continue beneath the surface, irrespective of the ups and downs of the prices on the markets. Ultimately, this issue is more important than the direction of prices, because what is at stake is the essence of the market mechanism. After all, the function of a true market is to match genuine supply and demand and thereby achieve ‘price discovery’, which is the critical information that the market generates and disseminates.

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